Franking Credits

Investors with money invested in Australian shares can benefit from gaining an understanding of the Dividend Imputation System and how Franking Credits work. For those investors able to and willing to invest in direct shares this understanding is all the more important.

One of the ways in which a company will reward its shareholders is by paying out a dividend. Dividends are the amounts paid out using profits that a company has made during the year and depending on the nature of the payout, usually come with an imputation or franking credit attached.

Let’s explore how this concept can benefit an investor in a little more detail.

History

Dividends are treated by the tax office the same as other income and are grouped together with other earnings to determine an overall taxable income amount. When a company earns a profit it is required to pay tax on that money earned. This tax is set at the corporate rate of 30%.

Before the dividend imputation system was introduced in 1987 by the Hawke/Keating government the tax office would tax both the company and the investor who received the dividend, in effect a form of double taxation.

With the introduction of the dividend imputation system, investors who receive a dividend will only be taxed the difference between 30% and their own marginal tax rate as the company tax has already been paid at the 30% rate.

This means that if an investor’s tax rate is 30% then they will not have to pay tax on the dividends and if the marginal rate is 46.5% then an investor will only pay the difference which is 16.5%.

In addition to this, since the year 2000 imputation or franking credits have become fully refundable which makes franking credits a powerful strategy that can be used in your investment planning.

Let’s take a look at this concept in more detail by using a case study.

Power of franking credits case study

You hold 625 shares in company XYZ Holdings for which you paid $16 per share making the total investment in this company $10,000.

XYZ Holdings makes $3 of profit per share and is required to pay 30% tax on that profit which is 90 cents, leaving $2.10 cents per share able to be either retained by the business for growth or paid out to you and other shareholders in the form of a dividend.

XYZ Holdings decide to retain about 40% of the profits to further grow the business and to pay shareholders the remaining $1.20 as a fully franked dividend. Attached to this dividend is a 30% imputation credit which you don’t physically receive but which you have to both declare in your tax return as income and claim back as tax rebate.

Let's take a closer look at the numbers:

Share price $16.00

# Shares Held 625

Investment (625 x $16)

$10,000

Dividend per share $1.20

Dividend Income (625 x $1.20)

$750

Franking credit

Franking Income ($750 x 30/70)

$321.43

Taxable income

($750 + $321.43)

$1071.43

Dividend yield

($750/$10,000)

7.5%

Not a bad return on your initial investment of $10,000.

Now let’s look at the effects of taxation on this investment by comparing four investors, all on different tax rates:

Investor 1

Investor 2

Investor 3

Investor 4

Tax rate

0%

15%

30%

45%

Dividend

$750

$750

$750

$750

Imputation credit

$321.43

$321.43

$321.43

$321.43

Taxable income

$1071.43

$1071.43

$1071.43

$1071.43

Gross tax payable

$0.00

$160.71

$321.43

$498.21

Franking credit rebate

$321.43

$321.43

$321.43

$321.43

Tax payable/ (refundable)

($321.43)

($160.71)

$0.00

$176.79

After tax income

$1071.43

$910.71

$750.00

$573.21

After tax equivalent yield

10.71%

9.11%

7.5%

5.73%

Investor 1 and 2 both receive refunds.

Investor 3 does not have to pay any extra tax despite having received $750 in income.

The higher income earner, Investor 4, has to pay some tax on his $750 dividend but he has reduced his tax rate on this income considerably due to the franking credits attached.

Strategies

How might this knowledge help you in your investment planning? Let’s take a look:

Investor 4 might decide to buy the parcel of shares in his spouse’s name who doesn’t earn any income and therefore take advantage of the capacity to gain a full refund of the franking credits instead of him having to pay an extra $176.79 in tax.

Investor 2 might be a SMSF in accumulation phase who uses the excess franking credit rebate to offset contributions tax and feels they can contribute slightly more than they were planning to given the benefit of the franking credits.

Investor 1 might be a SMSF in pension phase who doesn’t have to pay tax at all and who uses the franking credit refund to fund the pension payments they are required to make.

Investor 1 may be a retiree whose pension income is tax exempt and who doesn’t have any other income outside of the pension but who may have spare funds outside superannuation to invest and who can take advantage of the full refund of the franking credits associated with their investment to supplement their pension income.

Investor 3 might be an active investor who doesn’t have time to trade but who wants to supplement her income and uses an ex-dividend investing strategy to more actively manage her portfolio (explore this topic further at the ASX website )

Holding period rule

Obviously investing in shares that pay a fully franked dividend is a tax effective investment strategy so to prevent investors from taking advantage of the system the ATO has introduced some conditions in order for an entity to obtain a tax offset for franking credits

One of the important conditions that investors need to be aware of is the holding period rule which requires resident taxpayers to:

hold shares for at least 45 days (not counting days of purchase or sale, so in effect 45 becomes 47) to be eligible to receive franking credits of over $5000

have a minimum 30 per cent level of ownership risk.

Both these conditions will need to be taken into account when considering any investment strategy focused on dividends, especially where leveraged products like geared warrants are concerned.